Is there still anything to be said for the “liquidity drain” bear case — other than that it didn’t pan out?
I’m not sure, honestly. As a quick reminder, the thesis went something like this. A combination of factors including, but not limited to, a deluge of T-bill issuance post-debt ceiling deal, would likely sap liquidity and with it, risk assets’ joie de vivre. The other factors included ongoing QT on both sides of the pond, TLTRO repayments in Europe and the resumption of student debt servicing obligations in the US.
The crux of the matter was the T-bill tsunami and, specifically, whether RRP transformation (i.e., money market funds rotating out of the Fed’s repo facility and into bills) would mitigate reserve drain. So far, the answer is “Yes” — yes, money funds appear to be absorbing the lion’s share of the new supply. That’s a big deal, and it looks increasingly fatal for the “liquidity drain” bear case.
Cameron Crise underscored the point on Wednesday. “The great fear was that the reduction in Fed assets, combined with the Treasury rebuilding its general account balance following the debt-ceiling deal, would lead to a sharp reduction in bank reserves and a consequent tightening of liquidity,” he wrote, adding that “the sense was that even if bank reserves only bore 50% of the brunt of QT/TGA, the concomitant tightening of liquidity in some quarters would start to be felt.”
He called those fears “entirely misplaced.” Or at least so far. Money fund demand for bills “has been very substantial indeed,” he went on. “They have basically taken the other side of all of the QT/TGA changes over the last couple of months.” That’s effectively negated the main pillar of this particular bear case.
But the bears aren’t giving up on it. Or at least not entirely. “March’s bank depositor programs added close to $400 billion to the Fed’s balance sheet in a matter of weeks [and while that] was not equivalent to QE, we do think it had a positive impact on asset prices, particularly as the Treasury was draining its general account and unable to issue supply due to the debt ceiling constraint,” Morgan Stanley’s Mike Wilson wrote, adding that “with the regional banking system stable and the Fed’s QT ongoing, the liquidity backdrop should now be less constructive for equities.”
The familiar figure above shows Morgan Stanley’s liquidity indicator plotted with the S&P. The relationship was tight. Was. Now, it’s totally broken, which suggests either a sharp decline in equities or else that the relationship simply doesn’t hold anymore.
To reiterate: Positing a relationship between liquidity and risk assets is one thing. Trying to time the market based on that relationship is another. This has bedeviled strategists and traders for the entirety of the QE era, a period during which the only thing that grew faster than central bank balance sheets was market participants’ interest in the nexus between various measures of liquidity and risk asset performance.
Wilson continued. “With the Treasury issuing significant supply for the rest of this year, the TGA will likely no longer serve as a positive offset to QT,” he said. “In other words, the liquidity tailwind has likely also faded.”
We’ll see. But when it comes to Treasury’s cash rebuild and hopes that RRP transformation would mitigate reserve drain, it’s a “so far, so good” situation.
